Basel IV
Description
The second edition of the "Basel IV" handbook is updated with all publications up to March 2018 and also extensively enhanced with additional details, examples and case studies. The aim is to convince the reader that we are facing a new framework called "Basel IV" and not just a fine adjustment of the existing Basel III regulations. This book covers all new approaches for the calculation of RWA:
- the standardised approach (CR-SA) and the IRB approach for credit risk,
- the new standardised approach for counterparty credit risk (SA-CCR),
- both the standardised approach and internal models approach from the "fundamental review of the trading book" (SBA and IMA)
- the basic approach (BA-CVA) and standardised approach (SA-CVA) for the CVA risk,
- all new approaches (SEC-IRBA, SEC-ERBA, SEC-SA, IAA) for securitisations (incl. STS),
- the approaches for the calculation of RWA for equity positions in investment funds (LTA, MBA, FBA)
- the new standardised approach for operational risk (SA-OpRisk)
Because of the strong relation to the Pillar I requirements, the second edition covers the topics of interest rate risk in the banking book (IRRBB), large exposures and TLAC again. Additionally, the book contains a detailed description of the Pillar III disclosure requirements.
With the aid of a high-profile team of experts from countries all over the globe, the complexity of the topic is reduced, and important support is offered.
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Persons
Stefan Röth is a Senior Manager in the Regulatory Management division of PwC in Frankfurt; he advises banks and financial services providers on all aspects of banking supervision. Currently, he focuses on the impacts of "Basel IV" on the banking world. He has already given numerous lectures at specialist conferences and published several articles on this topic.
Content
Foreword 13
Preface 15
1. Chapter: Revision of the Standardised Approach for Credit Risk 17
1.1 Introduction 17
1.2 General aspects 19
1.2.1 Exposures to sovereigns 21
1.2.2 Exposures to public sector entities 22
1.2.3 Exposures to multilateral development banks 22
1.2.4 Exposures to banks 23
1.2.5 Exposures to corporates 28
1.2.6 Specialised lending 30
1.2.7 Subordinated debt instruments, equity and other capital instruments 32
1.2.8 Retail exposures 33
1.2.9 Exposures secured by real estate/Real estate exposure class 34
1.2.10 Additional risk weights for positions with currency mismatch 51
1.2.11 Off-balance sheet items 52
1.2.12 Defaulted exposures 53
1.2.13 Other assets 54
1.3 Use of external ratings 54
1.3.1 Recognition process for external ratings by national supervisors 54
1.3.2 Mapping of external ratings and use of multiple ratings 56
1.4 Credit risk mitigation techniques 58
1.5 Conclusions 62
Recommended Literature 64
2. Chapter: The Future of the IRB Approach 65
2.1 Introduction of the fundamentals of the IRB Approach (Basel II) 67
2.1.1 A non-quantitative introduction to the IRB risk weight formula 67
2.1.2 The adoption of the IRB Approach 73
2.1.3 Calculation of RWA and EL 74
2.1.4 Minimum conditions for entry and ongoing use 81
2.1.5 Approval and post-approval process: Home/host coordination 88
2.1.6 Decision for application 89
2.2 Basel Committee's initiatives to improve the IRB Approach 90
2.2.1 Introduction 90
2.2.2 Scope of application of internal models 90
2.2.3 Partial use of the IRB Approach 94
2.2.4 Risk parameter floors as an instrument of RWA variability reduction 97
2.2.5 Parameter estimation practices 99
2.2.6 Expected impact on banks 102
2.2.7 Conclusion 106
2.3 EBA regulatory reform and the revised supervisory assessment methodology 107
2.4 Definition of Default 109
2.4.1 Past-due criterion in the definition of default 111
2.4.2 Indications of unlikeliness to pay 113
2.4.3 Application of the definition of default in external data 117
2.4.4 Consistency of the application of default definition 118
2.4.5 Application of default definition for retail exposures 118
2.4.6 Criteria for the return to the non-defaulted status 119
2.4.7 Materiality thresholds 120
2.4.8 Implementation of changes 121
2.4.9 Impact of new default definition on RWA 122
2.5 Risk estimates 122
Recommended Literature 138
3. Chapter: The New Standardised Approach for measuring Counterparty Credit Risk (SA-CCR) 139
3.1 Counterparty credit risk 139
3.1.1 Definition of counterparty credit risk 139
3.1.2 Measuring counterparty credit risk in the EU 139
3.1.3 Background and motives for introducing the SA-CCR approach 141
3.2 Side note: Calculating EAD with the current exposure method 141
3.3 Measurement of counterparty credit risk according to SA-CCR 145
3.3.1 Exposure at Default 145
3.3.2 Current replacement cost 145
3.3.3 Potential future exposure 147
3.3.4 Calculation example: EAD determination under SA-CCR 158
3.4 Use of simplified approaches 159
3.4.1 Simplified SA-CCR 160
3.4.2 Revised original exposure method 161
3.5 Expected impact on the banking industry 161
Recommended Literature 162
4. Chapter: The new securitisation framework 163
4.1 Introduction 163
4.2 The securitisation framework under Basel II 164
4.2.1 Scope and definitions 164
4.2.2 Exclusion of securitised exposure from the calculation of risk-weighted exposure amount 165
4.2.3 Treatment of securitisation exposures 167
4.3 Revisions to the securitisation framework under Basel IV 168
4.3.1 Criticism of the existing rules 168
4.3.2 New approaches and a revised hierarchy for the determination of risk-weighted exposure amounts 171
4.3.3 Risk weights for securitisation positions when complying with STC criteria 184
4.4 General Conclusions 189
Recommended Literature 190
5. Chapter: Capital Requirements for Bank's Equity Investments in Funds 193
5.1 Overview 193
5.2 Trading book vs banking book boundary 194
5.3 Own funds requirements for funds in the banking book 195
5.3.1 Scoping and hierarchy of approaches 195
5.3.2 Funds under the standardised approach 196
5.3.3 Funds under the internal ratings-based approach (IRB) 199
5.3.4 Leverage adjustment under the LTA and the MBA 200
5.3.5 Treatment of funds that invest in other funds (target funds, fund of funds) 201
5.4 Summary and conclusion 202
Recommended Literature 203
6. Chapter: Fundamental Review of the Trading Book: A New Age for Market Risks . 207
6.1 Introduction 207
6.2 Revised trading book boundary 208
6.2.1 Revised boundary of the trading and banking books 209
6.2.2 Reallocation of positions between books 212
6.2.3 Internal risk transfer 213
6.2.4 Example for national implementation: Boundary requirements and thresholds in the EU 214
6.3 The revised standardised approach for market risks 215
6.3.1 Linear and non-linear price risks 217
6.3.2 Default risk charge 229
6.3.3 Residual risk add-on 230
6.3.4 Simplified alternative to the standardised approach 231
6.3.5 Example for national implementation: The implementation of the SBA in the EU 233
6.4 Internal Models Approach for market risk (IMA-TB) 235
6.4.1 Regulatory background and goals 235
6.4.2 Procedural and organisational challenges 236
6.4.3 Methodological amendment 237
6.4.4 Impact on capital requirements 248
6.5 Business implications and impact in the financial markets 251
6.5.1 Market microstructure 252
6.5.2 The competitive landscape 253
6.5.3 Possible solutions and workarounds 254
6.6 Optimisation considerations 256
6.6.1 Selective IMA - general aspects 257
6.6.2 Example I: Diversification benefit realisation 258
6.6.3 Example II: Optimisation of risk factors 258
6.7 Conclusions 259
Recommended Literature 262
7. Chapter: CVA Risk Capital Charge Framework 265
7.1 Credit Valuation Adjustment 265
7.1.1 Definition of the term "Credit Valuation Adjustment" 265
7.1.2 Background of the regulatory CVA 266
7.1.3 Revision of the CVA framework 267
7.1.4 Hierarchy of approaches 269
7.2 FRTB-CVA framework 270
7.2.1 Regulatory requirements for the application of the FRTB-CVA framework 270
7.2.2 Exposure value for the FRTB-CVA 272
7.2.3 Standardised approach for CVA (SA-CVA) 273
7.3 Basic CVA framework 277
7.3.1 Side note: Calculation of the CVA Risk Capital Charge under the current standardised method according to Basel III 277
7.3.2 Regulatory requirements for the application of the basic CVA framework 280
7.3.3 Exposure value for the basic CVA 280
7.3.4 Determination of regulatory capital requirements based on the basic CVA framework 281
7.4 Additional aspects and expected effects 285
Recommended literature 286
8. Chapter: Operational Risk 289
8.1 Introduction 289
8.2 Current methods pursuant to Basel II 290
8.2.1 Basic Indicator Approach and Standardised Approach 290
8.2.2 Advanced Measurement Approaches 292
8.2.3 Criticism of the existing approaches 293
8.3 Overview: From Basel II to Basel IV 293
8.4 Standardised Approach for operational risk (BCBS 424) 294
8.4.1 Methodology of the SA 294
8.4.2 Minimum standards for the use of loss data 301
8.5 Future impact 302
8.5.1 Capital requirements for OpRisk 302
8.5.2 Practical considerations 302
8.5.3 Disclosure 303
8.6 Conclusion 303
Recommended Literature 305
9. Chapter: Capital Floors 307
9.1 Introduction 307
9.2 Reasons for the new capital floor 309
9.3 Basel IV Capital Floor 312
9.3.1 Capital Floors in Basel I and II 313
9.3.2 Calculation of the floor 317
9.3.3 Transitional Cap Rules 318
9.3.4 Choice of which standardised approach 320
9.3.5 Global implementation 320
9.4 Interactions and interdependencies to other Basel IV rules 321
9.4.1 Overview of the goals and quantitative impact of the capital floor and other Basel IV changes 323
9.4.2 Impact of the capital floor on the standardised approaches and their implementation 324
9.4.3 Optimisation of the standardised approaches 325
9.4.4 Impact of the capital floor on pricing models 327
9.4.5 Relationship between the capital floor and the scope of application of the IRB Approach 331
9.5 Conclusions 332
Recommended Literature 333
10. Chapter: New Basel Framework for Large Exposures 335
10.1 Background 335
10.2 Scope 336
10.3 Large exposure limits 336
10.4 Eligible capital 338
10.5 Counterparties and connected counterparties 339
10.6 Definition of exposure 341
10.7 Assessment base 342
10.7.1 On and off-balance sheet items in the banking book 342
10.7.2 Counterparty risk 342
10.7.3 Trading book items 343
10.8 Recognition of credit risk mitigation 343
10.9 Exemptions 345
10.10 Look-through of funds and securitisations 347
10.11 Regulatory reporting 350
10.12 Implementation of the updated framework in the CRR II 350
10.13 Summary 351
Recommended Literature 354
11. Chapter: Disclosure 357
11.1 Introduction 357
11.2 Disclosure guidelines 358
11.3 Risk management, key prudential metrics and risk-weighted assets (RWA) 362
11.4 Linkages between financial statements and regulatory exposures 365
11.5 Composition of capital and TLAC 368
11.6 Macroprudential supervisory measures 371
11.7 Leverage Ratio 372
11.8 Disclosures related to liquidity 373
11.9 Credit risk 378
11.9.1 General information on credit risk 380
11.9.2 Credit risk mitigation 383
11.9.3 Credit risk under the standardised approach 384
11.9.4 Credit risk under the IRB Approach 385
11.10 Counterparty credit risk 386
11.11 Securitisation 390
11.12 Market risk 391
11.13 Interest rate risk in the banking book 399
11.14 Remuneration 400
11.15 Benchmarking 402
11.16 Operational risk 403
11.17 Credit valuation adjustments 406
11.18 Asset encumbrance 407
11.19 European implementation 408
11.19.1 European implementation of phase I 408
11.19.2 European implementation of phase II 410
11.20 Conclusions and expected effects 410
Recommended Literature 412
12. Chapter: Interest Rate Risk in the Banking Book (IRRBB) 415
12.1 Introduction 415
12.2 Principles for treatment within the framework of Pillar 2 416
12.2.1 Definitions 416
12.2.2 The twelve Principles for the management of IRRBB 416
12.2.3 Interest rate shock scenario design 419
12.2.4 The EBA guidelines on the management of interest rate risk arising from non-trading book activities 420
12.2.5 Similarities and differences between the BCBS Principles and the EBA Guidelines 421
12.3 The Standardised Framework 423
12.3.1 Introduction 423
12.3.2 Assigning positions to time buckets 424
12.3.3 Estimating the impact on EVE 426
12.3.4 Calculation of minimum capital requirements 427
12.4 Conclusion and outlook 427
Recommended literature 428
13. Chapter: TLAC and MREL - The Extension of the Regulatory Capital Definition and the Scope of Supervision 429
13.1 Background 429
13.2 TLAC 431
13.2.1 TLAC implementation 431
13.2.2 TLAC calibration 431
13.2.3 TLAC eligible instruments 431
13.2.4 Resolution entities and internal TLAC 432
13.2.5 TLAC holdings 433
13.2.6 TLAC-Reporting 435
13.2.7 TLAC disclosure 436
13.3 MREL 437
13.3.1 MREL implementation at EU level 437
13.3.2 MREL calibration 439
13.3.3 Resolution entities and internal MREL 445
13.3.4 MREL holdings 446
13.3.5 MREL reporting 446
13.3.6 MREL disclosure 448
13.4 Outlook and summary 448
Recommended Literature 450
14. Chapter: Strategic Implications 453
14.1 Introduction 453
14.2 The capital squeeze 453
14.2.1 RWA impact 453
14.2.2 Impact on capital 455
14.3 How to cope with Basel IV - Strategic implications 458
14.3.1 Capital management 459
14.3.2 Portfolio composition 460
14.3.3 Product structure 462
14.3.4 Operations 462
14.4 Conclusion 463
1
Revision of the Standardised Approach for Credit Risk
Luis Filipe Barbosa Nikolaos Kalogiannis Friedemann Loch and Sebastian L. Sohn
1.1 Introduction
As the original Basel I rules for credit risk - being the most relevant risk type for banks - were lacking an appropriate degree of risk sensitivity, they were considered to no longer adequately meet supervisory requirements. Therefore, aiming at greater economic differentiation of the credit risk, with a better recognition of exposures characteristics and a more appropriate reflection of risk-mitigation techniques, the Basel Committee developed two different approaches for the quantification of credit risk which represented the core elements of Basel II. The so-called "Standardised Approach" (standardised approach for credit risk, hereinafter also referred to as "SA") available to all banks and also - subject to supervisory approval - an "Internal Ratings-based Approach" (hereinafter referred to as "IRB Approach"), in which for the first time banks were permitted to use internal methods to determine risk parameters (e.g. probability of default) that could be used to quantify the capital requirements of credit risk for regulatory purposes. Figure 1.1 illustrates both approaches available to quantify the capital requirements for credit risk.
Figure 1.1: Approaches for credit risk quantification
Under the SA, external ratings are used as a basis for the determination of risk weights and the quantification of capital requirements for certain exposure classes. The mapping of external ratings to risk weights, as well as the extent of eligible credit risk mitigation instruments and calculation of the risk mitigation effect, are entirely specified by the regulator. In contrast, the IRB Approach offers various options for internal estimation of risk parameters (see also Chapter 2 on the IRB Approach).
The quantification of risk-weighted assets (RWAs) and capital requirements under the SA is based on a set of components displayed in Figure 1.2.
Figure 1.2: Elements to determine risk-weighted assets under the standardised approach
It should also be highlighted that, under the standardised approach, exposures have to be risk-weighted net of specific provisions (including partial write-offs).
Once the Basel II rules on the standardised approach were finalised and implemented in the various national legislations it soon became apparent that the intended improvements in risk sensitivity within the standardised approach of Basel II were primarily achieved for claims on central governments - and depending on the national implementation also for banks. In many jurisdictions external ratings were only available to a small number of predominantly large corporates. The vast majority of corporates did not have any external ratings and had to be classified as "unrated" which resulted in the same risk weight as under Basel I.
Over time - and especially within the financial market crisis starting in 2007 - the insufficient risk sensitivity of the standardised approach and the use of external ratings for supervisory purposes were increasingly criticised.
Within the Basel III framework the Basel Committee changed the structure and definition of regulatory capital and introduced new regulation on liquidity and leverage, but did not modify any elements of the standardised approach for credit risk.
As a response to the ongoing criticism on the standardised approach, the Basel Committee published an initial consultative paper on a revised standardised approach in December 2014, followed by a second consultative paper in December 2015. The approaches consulted in these papers were aimed at achieving a higher risk sensitivity without further increasing the complexity of the standardised approach. Another intention was to increase the comparability of capital requirements between banks by reducing differences in capital requirements between the standardised approaches and the IRB Approaches. In addition it is intended to limit national discretions in the application of the standardised approach. Moreover, the Basel Committee plans to reduce differences regarding the definition of exposure classes under the standardised approach and the IRB Approach. An additional aspect of the revision of the standardised approach is to decrease the mechanical dependence on external ratings. While the first consultative paper contained extremely wide-ranging modifications in this respect by removing the use of external ratings completely, the second consultative paper still allows the use of external ratings, the same holding true in the new Basel regulation. The use of external ratings is, however, complemented by additional requirements requesting the institution to conduct an independent credit risk assessment ("due diligence").
In contrast to the current requirements, the revised standardised approach needs also to be implemented by all IRB banks in the future, as the capital requirements under the standardised approach will serve as a floor for the capital requirements under the IRB Approach (see Chapter 9). Presently, IRB banks have the option of determining the capital floor based on the Basel I provisions ("Basel I Floor").
Securitisation exposures are addressed in the securitisation standard (Chapter 4). Credit equivalent amounts of OTC derivatives, exchange traded derivatives and long-settlement transactions that expose a bank to counterparty credit risk are to be calculated under the counterparty credit risk standards (Chapter 3). Equity investments in funds and exposures to central counterparties must be treated according to their own specific frameworks (Chapter 5).
Hereinafter the revisions based on the final Basel regulation are summarised and compared to the proposed changes of the first and second consultative papers as well as to the current requirements of the CRR.
1.2 General aspects
The Basel Committee's revision of the standardised approach for credit risk comprises all exposure classes, except for claims on sovereigns, central banks and public sector entities (PSEs) - in the latter case, only minor editorial changes have been made to remove reference to current options for banks. They are not included as the Basel Committee is considering these exposures as part of a broader and holistic review of sovereign-related risks.
While the first consultative paper replaced the use of external ratings by other risk drivers, the second consultative paper as well as the final Basel regulation still allows for the use of external ratings. However, in some countries (the USA for instance), the use of external ratings for regulatory purposes is not admitted. For these jurisdictions, and also for all exposures to unrated counterparties, a newly developed Standardised Credit Risk Assessment Approach (SCRA) will be available.
In order to avoid mechanistic reliance on external ratings, the due diligence requirements already included in the first consultative paper were further specified. Even in cases where ratings are used, due diligence is needed to assess the risk of exposures for risk management purposes and whether the risk weight applied is appropriate and prudent. This is to ensure that banks have an adequate understanding, both at origination and on a regular basis (at least, annually), of the risk profile and characteristics of their counterparties. Should the due diligence analysis reveal a higher risk compared to the risk weight based on external ratings, the higher risk weight has to be applied. However, if the due diligence analysis should reveal a very low risk compared to the external rating, it cannot result in a more favourable risk weight then determined by external ratings.
The exact extent and content of due diligence requirements is yet to be specified; the consultative paper only refers to the presently existing Pillar II-requirements of Basel II. Under Pillar II, banks are required to have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties. In this context, the importance of internal ratings as a tool to monitor credit risk on a borrower level is explicitly emphasised.
Banks need to ensure that they have an adequate understanding of the risk profile of the borrower at origination and thereafter on a regular basis (at least annually). They must take reasonable and adequate steps to assess the operating and financial performance levels and trends through internal credit analysis and/or other analytics outsourced to a third party, as appropriate for each counterparty. Banks need to be able to access information about their counterparties on a regular basis so that they can complete the due diligence analyses.
It is also necessary that banks can demonstrate to the supervisory authority that their internal policies, processes, systems and controls ensure an appropriate assignment of risk weights to counterparties.
Currently, it is expected that the majority of SA institutions in many countries will be largely compliant with the due diligence requirements due to their existing practice of applying rating procedures for bank-internal processes, even in their capacity as SA institution. It remains to be seen, however, how these requirements will be implemented at the European level.
1.2.1 Exposures to sovereigns
Exposures to...
